“Like sheep to the slaughter… they were led.”
The herd mentality has been discussed in a great deal in academic literature and here is where it gets interesting especially because this mentality has been referred to primarily in the equities market. The old adage that goes that if you follow the herd, you will inevitably get slaughtered. And this truth has held firm as far as the equities market is concerned.
But when it comes to cryptocurrency markets, does this old adage hold true?
Two researchers Ajaz and Kumar (2018) tested this hypothesis out. To do so, they studied Bitcoin as it is the progenitor of the crypto world.
It is clear by now that Bitcoin has gone through many price fluctuations of great extremes and many observers and skeptics have gone so far to say that it is in a bubble. Research that has gone back as far as 2014 with researchers such as Garcia (2014) and Dowd (2015) have corroborated evidence on this extreme volatility of what is still termed as a “risky investment”. After all, the argument is that the value of the asset is virtually zero because it is only worth as much as what the next person is willing to pay for it.
Regardless of the various skeptical comments, one cannot doubt the growth of the cryptocurrency markets. Even to the point where financial institutions have taken note. Goldman Sachs has given its stamp of approval in dipping its toes into this market for clients. Ditto JP Morgan, even though Jamie Dimon does not like it at all, he concedes that if his clients like it, he needs to provide for it. In a world where money speaks louder than words, it makes perfect sense. Insurance companies are also dipping their toes into this space and the recent talk is about getting the stock market decentralized with the blockchain as well.
It makes sense for one to consider the fact that the growth rate is driven by behavioural biases rather than backed by strong fundamentals (albeit it depends on which side of the fence you sit on). There is a lot of irrational behaviour observed – even at Bitcoin conventions/conferences, so to speak. Dollar note tearing, shirt ripping off on stage, and the like, are just manifestations of the underlying issues held by maximalists.
And this is where herd behaviour needs to be looked at seriously. What drives it and how can you protect yourself from it as an investor or trader?
There is a lot of unreliable information masquerading as “truths”, that when swallowed whole by enough people, form the rat poison and catalyst for another crash. FOMO, or what they call it, is one of the drivers too. During extreme market movements, it can be clear that those who are invested in an asset can end up being driven to move with the market consensus too. In the crypto world, there are reasons why herding is a big concern. Firstly, it is unlike traditional markets where there are protective measures in place against fraudulent activities. Second, the outsized influence of the current crypto market affects the market as a whole. In the traditional markets, one stock crash, even a major one, may just be a small ripple in the entire ocean. But because the top few cryptocurrencies account for more than half the market value, a small movement can cause earthquakes felt throughout the crypto market.
Here is what our researchers found with regards to herding:
- Regardless of the market type (bull or bear), there is always herding behaviour. Crypto investors will end up exhibiting certain extremes in behaviour in reaction.
- Herding depends on the amount of market activity more than it is on the volatility. This would mean that when there is an upward momentum, investors generally tend to pile in more and more to create greater and greater upswings. However, when it comes to a crash, the entire herd follows through in selling. Hence drops are equally as steep as climbs. This can be seen in periodic explosive buy and sell behaviours.
To capitalise on this, it corroborates with other forms of research that showcases that active management in the crypto markets always tend to produce more profits rather than a pure buy and hold behaviour. The key is to listen closely to the direction of the market activity – and other researchers’ findings, social listening for sentiments matter a lot in getting the formulation right. As a fund manager or an individual investor, you may want to take a closer look in that direction.
Yours,
Chief Editor,
BBA Market Perspectives 2021
(ps don't get killed in a herd stampede!)
